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Thursday, June 7, 2012

Nudge by Richard H. Thaler and Cass R. Sunstein

Source of book: Borrowed from the library

First
of all, I must state that my wife is a hypocrite. It’s true. But first,
let me explain what this fascinating book is about.

Thaler
is an economist, while Sunstein is a lawyer, but was appointed to serve
in the Obama administration. Their book, published before the election,
addresses the question of default settings in public policy, and the
use of what they call “nudges” to assist people in making good
decisions.

Thaler
and Sunstein advocate a position they call “libertarian paternalism.”
At the heart of this concept is the idea of a default setting - that is,
what happens when people do not take action. A great example of this is
the 401(k) retirement account. In order to start contributing to such
an account, one must take action by signing up. In addition, one must
choose which investments are used. The default setting at this time is
“no contributions,” which is surely a poor default. This is doubly (or
more) so, in cases where an employer matches contributions. The default
is to lose free money!

There
are other possible defaults here, including a default that 401(k)
contributions are set at the maximum, or that they are set at the level
of the maximum employer match. Another possibility is that the employee
be forced to explicitly choose before he or she receives the first
paycheck. The result of the current default is that nearly everyone says
they want to contribute more, but far too many never overcome the
inertia and sign up.

A
related problem is that of choosing investments. Most plans have
numerous funds as options, and most investors are fairly unsophisticated
when it comes to choosing them. Most of us would prefer some guidance
to appropriate investments. (I am an exception here: I love doing the
research, and educated myself before opening my own SEP IRA accounts.)
The point here is that it suddenly becomes extremely important to set
appropriate defaults. As the authors point out, something
will be the default: it is impossible to avoid it. Space prevents the
discussion of the Swedish social security system. (Yes, it’s true. The
socialist Swedes have partially privatized their social security
system.) The authors’ look at the results of various defaults tried by
the Swedish government over the last decade is illustrative of the power
of the default setting. Now
this is where my wife is a hypocrite. She has generally been purely
libertarian in her philosophy toward retirement contributions - far more
libertarian than me. Although she does contribute to her retirement at
the matching rate, she set her accounts essentially at the default, and
cannot really explain what she has invested in and why. She has accepted
the defaults, and many others are like her. (I mean nothing negative here - it's just human nature - but many libertarians seem intent on denying or ignoring this fact.)

Here
is where Thaler and Sunstein believe in the use of “nudges.” These are
essentially the use of defaults and reminders in ways that do not
abridge the freedom of choice, but assist those who tend to settle for
defaults in making better decisions. In order to qualify as a nudge, the
authors believe that the cost of overriding the nudge should be as low
as possible - preferably zero. In the above example, if the default for
retirement contributions was, say, five percent of income, it would
qualify as a nudge as long as the employee could easily opt out. (The
change would be from “opt-in” to “opt-out.”)

Central
to the idea of the “nudge” is that people are “humans” rather than
“econs.” The typical libertarian economist believes that people always
educate themselves, consider the options, and pick what they want. In
other words, they make decisions that are in their best interest. People
like this exist, and the authors call them “econs.” Most of us,
however, are “humans” in how we behave. We fail to act logically in all
situations. We procrastinate, and react rather than think - at least in
some cases. We are particularly prone to get into trouble on serious
issues wherein the cost is incurred immediately, but the reward is in
the future. We struggle to get complex issues correct, which is a
particular problem in cases where we do not get the opportunity to
practice, such as in saving for retirement. These are the precise
scenarios where the authors think that nudges can be helpful.

A
great example of the “human” tendency can be seen in an experiment
involving intentionally stale popcorn, which was served in different
sized containers. It was rather universally agreed among the
participants that the popcorn was gross, and yet those with larger
containers ate more. By a lot. Even though they hated the popcorn.

Another
interesting “human” tendency was to have difficulty assessing risk. For
example, most people will estimate the likelihood of divorce to be
fifty percent - at least for other people. For themselves, they
consistently estimate a zero chance. Obviously, this cannot be right,
but the human tendency is to disregard certain risks and overestimate
others. (This could be an entire book by itself.)

Another
reason the authors think nudges are important is that humans tend to
follow the herd. We naturally want to do what we believe other people
are doing. By shifting the default, the herd mentality can be used to
produce better results. The authors cite the Jamestown Massacre as a
negative example, but also note that the herd mentality has also been
used to reduce littering. This part of the discussion was seriously
unsettling, particularly the experiments that have been done involving
peer pressure. People are amazingly unwilling to stand for their own
opinions if they have to do so against a crowd. On the positive side, it
was shown that consistent and unwavering people can have immense
influence for good, as well as evil.

Libertarians,
of course, tend to oppose nudges, for a number of reasons, some better
than others. The authors are proposing what they believe is a third way,
between the “command and control” paradigm of modern, post Franklin
Roosevelt liberalism; and the laissez faire
approach of libertarian conservatism. The authors correctly note that
many companies and individuals have a strong financial incentive to
cater to people’s ignorance and frailties and exploit them. A good
example cited here is the mortgage business, where fine print and
complexity are routinely used to hide the true cost from consumers.

The
goal that the authors set is to determine how to use nudges, rather
than command and control schemes to protect the less sophisticated and
the vulnerable. The intention is to benefit the “humans”, with a minimal
cost to the “econs.” In the context of retirement, there should be a
miniscule cost - if any - to a default that leads to a greater
investment in retirement by those who fail, for whatever reason, to go
beyond the default. It should not bother those of us who actively manage
our retirement accounts if someone else also does well. If it does,
perhaps we should be evaluating why we wish to see others hurt. Do we
just want to look down on others we deem less intelligent than
ourselves? Something to ponder.

I
felt that the authors made their point well, and present a powerful
argument in favor of libertarian paternalism. It is with regret that I
note that, despite Sunstein’s presence, the Obama administration has
chosen in most cases to go with a command and control approach, rather
than a “freedom and nudge” approach as that advocated by the authors. I
think that the “third way” proposal would be attractive to both sides of
the aisle: more protection against our frailties (and from
exploitation), combined with greater freedom of choice - and from
onerous regulatory compliance.

Note
on some specific proposals: The authors address a few ideas, such as
the use of a carbon tax or a cap and trade scheme to reduce pollution.
They contrast it, however, with a command and control scheme, in which
byzantine or draconian regulations cause costs to both those who pollute
and those who comply. They also come down in favor of school vouchers,
as increasing freedom, while setting defaults so that it is harder for
the more sophisticated to game the system. They also advocate for
privatizing marriage. All of these proposals are worth considering,
whether you agree with them or not. I thought they were food for
thought, and should be considered in contrast to the current state of
affairs, not just in the abstract. Note on peer pressure: A quote from this section made me smile, although it is not directly on point:

Conventional
wisdom has it that if two people live together for a long time, they
start to look like each other. This bit of folk wisdom turns out to be
true. (For the curious: they grow to look alike partly because of
nutrition - shared diets and eating habits - but much of the effect is
simple imitation of facial expressions.) In fact couples who end up
looking alike also tend to be happier!

Note
on notes: The authors use their own version of a nudge in how they
format the notes, which they explain at the outset. Most citations and
other notations are presented as endnotes at the back of the book. These
are interesting to people like me, who occasionally wish to check a
citation source. However, certain other notes, which the authors assume
the average reader would like to see immediately, without flipping to
the back, are placed as footnotes. I wish more authors did things this
way. I hate having to go all the way to the end for a note that can be a
useful explanation of the text, but would hate to have all the
citations right there and in the way. Brilliantly done!Note
on Shel Silverstein: The authors wished to use Silverstein’s poem
“Smart” as an illustration. It was perfectly on point, and charming.
Here is how the authors describe what happened:

To
analyze the question, let’s start with a simple example inspired by a
wonderful poem by Shel Silverstein (1974) entitled “Smart.” The poem is
fun as well as brilliant, so if you have a computer nearby, we suggest
you type “Smart” and “Shel Silverstein” into Google and read the poem
now.* We will wait for you to get back before continuing.

*Silverstein
had personally given Thaler permission to use the poem in an academic
paper published in 1985 - he said he was tickled to see his work appear
in the American Economic Review
- but the poem is now controlled by his estate, which after several
nudges (otherwise known as desperate pleas), has denied us permission to
reprint the poem here. Since we would have been happy to pay royalties,
unlike the Web sites you will find via Google, we can only guess that
the managers of the estate (to paraphrase the poem) don’t know that some
is more than none.

Since I think I can get away with quoting a single poem under the fair use doctrine, I will reproduce it here.

About Me

I'm a middle aged solo practice lawyer, married with 5 children. When we married, my wife and I agreed to share the kitchen and the library. We still fit in the kitchen, but are running out of room in the library. On a typical evening, you might find our seven noses buried in books. I continue to play violin with the Bakersfield Symphony Orchestra, as I have since 1996. I also write for and serve on the editorial committee of the Res Ipsa Loquitur, the official publication of the Kern County Bar Association. On weekends, if you see a small army out on the trail, don't panic. We're pretty harmless...
The blogs on my list are primarily family and friends, plus a few that I just like to follow.
This blog focuses on what I am reading as I continue the process of learning and exploration. I also talk about hiking, music, me, and issues that I care about.